Wednesday, August 05, 2009

Corporate Governance in Banks

The global economic crisis which started in the year 2007 has compelled political authorities in many countries to examine the role played by banks in causing the mayhem.Predictably, the main focus has been on limitations of corporate governance in banks and other financial institutions. In the UK, the Chancellor of the Exchequer appointed in February 2009 Sir David Walker, a former financial services regulator, to carry out a thorough review and to make recommendations for improving what should be the first line of defence against economic meltdown, namely corporate governance. The Chancellor lamented that standards of corporate governance were not healthy enough to check the reckless risk-chasing indulged in by bank executives.

Report and its significance : Sir David Walker released a Consultation Document titled "A review of Corporate Governance in UK banks and other financial industry entities" on 16 July 2009. This is a comprehensive report incorporating preliminary recommendations on various aspects of governance including 1) Board size, composition and qualification, 2) Functioning of the Board and evaluation of its performance, 3) the role of institutional shareholders, 4) Risk Governance and 5) Remuneration.

Expectedly, the report has already attracted criticism from various quarters. It is worthwhile studying the report with the twin objectives of knowing (a) whether recurrence of a similar crisis in future can be prevented and (b) relevance of the report to India. It is note-worthy that after meeting the chiefs of major banks in connection with First Quarter Review of Monetary Policy for the year 2009-10, the Governor of Reserve Bank of India issued a press statement wherein he emphasised the importance of governance in following words: "A big medium term challenge is to improve the investment climate and expand the absorptive capacity of the economy by giving a big thrust to Governance reforms , without which it is difficult to inspire the trust and confidence of potential investors". Earlier on 1st July 2009, RBI issued a master circular on corporate governance which inter-alia states," The need for good corporate governance has been gaining increased emphasis over the years. Globally, companies are adopting the best corporate practices to increase the investors' confidence as also that of other stakeholders". It is clear therefore that RBI is keen to benchmark governance standards of Indian banks with global best practices. Hence, studies on corporate governance in the UK and other countries are relevant for our country also.

Sir David Walker has observed that it is clear that governance failures contributed materially to excessive risk-taking in the lead up to the financial crisis. He is further of the opinion that weaknesses in risk management, Board quality and practices, control of remuneration and exercise of ownership rights need to be addressed in the UK and INTERNATIONALLY to minimise the risk of a recurrence. However, he acknowledges that better governance alone will not guarantee that there will be no repetition of the recent highly negative experience for the economy and for society as a whole but will make a rerun of these events materially less likely. In other words, corporate governance is a necessary but not sufficient condition for preventing global economic crises.

The report contains 39 recommendations ; the more significant among them are discussed below with relevance to India.Role of non-executive directors : The report recommends that in order to ensure that NEDs (non-executive directors) have the knowledge and understanding of the business to enable them to contribute effectively, the Board should provide "thematic business awareness sessions" on a regular basis which may be reviewed by the chairman every year. Indian experience in this regard is different. Non-executive directors in our banks ( and other industries also) are generally well versed with the particular business. Unfortunately, they feel obligated to promoters or appointing authorities and this psychological nexus has prevented the non-executive directors from maximising their contribution. It speaks ill of corporate governance that banks' top managements take active interest in election of their favoured candidates as representatives of shareholders. Such "favoured" non-executive directors cannot be expected to be objective in their role. It is high time that RBI admonished banks suitably in this regard.

Chairman and the Board : The report expects the chairman to commit a substantial portion of his time, probably not less than two-thirds, to the business of the entity. In India, chairpersons of public sector banks are full time appointees. The governance problem here is that the same person wears two hats, one as an executive and the other as the chair of policy-making Board. RBI is advising private banks to split the post of Chairman-cum-Managing Director. This has already been done in some private sector banks. It is to be seen how much time is spared by non-executive chairman for affairs of the bank.

External assessment of Board's effectiveness : One salubrious recommendation proposes a formal and rigorous evaluation of Board's performance with external facilitation of the process. This is very much desirable for effective governance though the modus operandi may pose many challenges. In India, effectiveness of Boards of banks is assessed by RBI through AFI (Annual Financial Inspection). This is done mainly from regulatory viewpoint. In addition, banks may pro-actively subject themselves to assessment by professional bodies like National Institute of Bank Management. This becomes all the more desirable because corporate governance should not be treated merely as a regulatory requirement. It is useful for a bank as competitive strength to enlarge its business because depositors and borrowers trust a well-governed bank much more than a bank which is lackadaisical in governance.

Expectations from institutional investors : The report explicitly expects institutional investors to play a sustained role rather than act as traders in equity. Sir David wonders, "Should we make it easier for long-only institutions to exert influence by having different weighted voting shares? Should shareholders get more voting oomph if they have held stock for a year?" This is a suggestion worth studying in the Indian context also. Institutions should be encouraged to play a more dynamic role in ensuring corporate governance. RBI will need to take a second look at ceiling on voting rights which is acting as a dampener to more active participation by institutions.

Transparency promotes better governance. The report expects fund managers and institutions to disclose their voting record ; it is also suggested that policies in respect of voting should be disclosed on their websites. A similar initiative in our country will help institutions like the LIC to avoid getting into governance issues in investee companies.

Risk Management : Management of risk is an integral part of corporate governance.It is a matter of pride for RBI and commercial banks in India that proposals made by Sir David Walker are already practised here.For example, the report suggests establishment of a Board-level Risk Committee separate from Audit Committee. This has already taken firm roots among banks in India. It is to the credit of RBI that it recognised long time back that Risk Committees need to be forward -looking unlike Audit Committees which are essentially backward-looking and therefore it advised commercial banks to set up separate Risk Committees.

The report also recognises the need for a Chief Risk Officer (CRO) who should partivipate in the risk management and oversight process at the highest level on an enterprise-wide basis and have a status of total independence from individual business units. Removal of CRO from office would require Board's prior approval. The Risk Committee should have access to external inputs to its work as a means of taking full advantage of relevant experience elsewhere.

It merits observation that though risk management system is well in place in Indian banks, there is a need for better coordination among banks so that they can learn from one another's mistakes instead of being forced to "reinvent the wheel".

Importance of risk management in banks and financial institutions cannot be over-emphasised. Weakness in risk management in banks - both commercial and central banks - was a major causative factor for financial meltdown. Though banks in India have weathered the storm without much systemic impact, RBI should not let its guard down but instead should learn from the experience of other countries. In this exercise, reports of various committees in different countries which study the economic malaise provide us food for thought.

Conclusion: Sir David Walker's consultative document addresses a plethora of issues impacting corporate governance in banks. RBI can use this as a sounding board to initiate serious discussions on governance. Since our central bank has already taken many credible steps to bolster corporate governance in banks, Indian banking system can easily become a pioneer in promoting healthy corporate practices.

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